1. Field of the Invention
The present invention relates generally to financial instruments, and more particularly, to the processing, valuing and trading of mortgage-related financial instruments.
2. Related Art
Consumers who desire to purchase a home usually borrow funds from a lender (e.g., a bank, finance company or the like, who are also called “originators” or “lenders”). As is well known in the relevant art(s), the legal document by which a consumer (i.e., the borrower) uses the mortgaged property as security to guarantee repayment of the loan is known as a mortgage (or mortgage loan).
Today, lenders sell over half of all mortgage loans they originate into the secondary market. By selling mortgage loans into the secondary market, lenders liberate capital in order to have funds to meet additional consumer demand for home mortgages. That is, the secondary market keeps the supply of money for housing widely available and ultimately lowers costs to borrowers.
Within the secondary market, lenders normally sell conventional mortgages (i.e., those not guaranteed or insured by the Federal Housing Administration or Veterans Administration) to a secondary market conduit or wholesaler, or directly to the Federal Home Loan Mortgage Corporation (“Freddie Mac”) or the Federal National Mortgage Association (“Fannie Mae”). The majority of these mortgages are sold to Freddie Mac or Fannie Mae (each, an “Agency”) for cash or in exchange for mortgage-backed securities. The Agencies pool, or “securitize,” the mortgages by creating mortgage-backed securities (“MBS”) backed by the purchased mortgages. Each respective Agency guarantees principal and interest payments on the MBS issued by it. Most newly issued MBS are sold (forward, usually one-to-three months) by participants in this market to broker-dealers, banks, pension funds, insurance companies, money market funds or other institutions. In other words, the MBS may be already sold prior to its issuance and/or delivery to the seller of that MBS.
Certain MBS are “TBA” (to-be-announced) eligible. In order to be TBA-eligible, newly-issued MBS must meet requirements determined, from time to time, by the Bond Market Association (“BMA”) of New York, N.Y., including requirements relating to pool size and the types and similarity of mortgages within such a pool. In addition to some basic information about the TBA MBS (for example its coupon and issuer), a purchaser of a TBA MBS typically knows only the general characteristics of the mortgages comprising it, such as the original terms (years) of the underlying mortgages. The underlying concept of TBA MBS is that they are fungible. In other words, they are sufficiently similar that it does not or should not matter to an investor which particular MBS it purchases so long as the MBS satisfies the investor's basic requirements as to coupon rate, term and other factors described above. The United States MBS market is the second largest component of the fixed-income investment market, and mortgages comprise almost twenty percent of the financial instrument universe.
In 1999, the Federal Reserve estimated the value of the MBS market at $2.3 trillion in outstanding supply, with $67 billion trading per day. Yet, the United States MBS market is the largest cash market in the world currently without a futures market counterpart. (In the 1970s and 1980s, the Chicago Board of Trade (the “CBOT”) launched a series of mortgage-based futures contracts (collectively, “GNMA Futures Contracts”) based on mortgage-backed securities guaranteed by the Government National Mortgage Association (“GNMA”), an agency whose guaranty of FHA/VA loans is backed by the full faith and credit of the United States government; yet, issues of timing and contract design eventually led to their demise.)
The total outstanding supply of MBS is second only to that of Treasury securities, and it is projected that the outstanding supply of MBS will eclipse that of Treasury securities within the next few years. In the absence of a viable futures market alternative, the cash forward market has, in many ways, evolved to fulfill the role typically played by a traditional futures market—but without many of the benefits. That is, the cash forward market lacks the efficiency, operational simplicity and credit protection afforded by an exchange-based futures market.
Further, mortgage market participants need a more effective hedging instrument in the wake of increased market volatility and events such as the liquidity crisis of 1998. Hedging, as will be apparent to one skilled in the relevant art(s), is, at its simplest level, a trade designed to reduce risk, such as protecting against a possible loss in an existing asset (e.g., a mortgage commitment) by buying or selling another asset (e.g., an option) that would offset the loss. Generally speaking, a futures contract is a standardized, transferable agreement between parties, which may be exchange-traded, to buy or sell an asset at a specified time in the future for a specified price. Futures contracts typically traded on regulated financial exchanges are marked to market daily (based on their current value in the marketplace). Futures contracts are explained in detail in John C. Hull, Options, Futures, and Other Derivative Securities, Prentice Hall, ISBN 0130224448 (4th ed. 2000), which is incorporated herein by reference in its entirety.
As with futures contracts for other types of assets, a corresponding option contract for MBS would enhance the appeal and utility of both instruments. Basically, an options contract, in this context, is an agreement between parties that represents the right to buy or sell a specified amount of the underlying contract at a specified price within a specified time. The parties to options contracts are purchasers who acquire “rights,” and sellers who assume “obligations.” Further, a “call” option contract gives one the right to buy the underlying security, whereas a “put” option contract gives one the right to sell the underlying security at a certain price. Typically, the purchaser pays the seller an up-front, non-refundable premium to obtain the option rights. Options contracts are explained in detail in the above-cited Hull, Options, Futures, and Other Derivative Securities. 
At present, over-the-counter (“OTC”) mortgage option contracts are available, but highly illiquid. The use of option contracts is of particular importance to mortgage originators, mortgage servicers and mortgage derivatives market players, who incur significant basis risk using Treasury futures and Treasury options, since changing spreads have adversely affected their hedging efficiency. Basis risk is the difference between the market value of the mortgages and Treasuries, for example, or such other mortgage hedge utilized.
Given the above, a mortgage a futures contract and a corresponding options contract linked to currently issued MBS coupons would reflect current and recent MBS production (issuance), provide an effective hedge, price transparency, and reduce counter party risks and operational demands.